The Price of Options Illiquidity

Abstract

The purpose of this paper is to examine the effect of illiquidity on the value of currency options. We use a unique dataset that allows us to explore this issue in special circumstances where options are issued by a central bank and are not traded prior to maturity. The value of these options is compared to similar options traded on the exchange. We find that the nontradable options are priced about 21 percent less than the exchange-traded options. This gap cannot be arbitraged away due to transactions costs and the risk that the exchange rate will change during the bidding process.ONE IMPORTANT ASPECT OF RESEARCH on the microstructure of financial markets is the effect of liquidity on financial assets. The early microstructure literature views liquidity as a determinant of transactions costs, affecting the bid-ask spreads but not equilibrium prices. 1 More recent studies that deal with the effect of liquidity on the prices of financial assets present evidence that illiquidity has an adverse effect on asset values~e.g., Amihud and Mendelson~1991! on bond prices, Silber~1991! on restricted stocks, and Longstaff~1995! on liquidity, volatility, and price!. 2 These papers deal with the effect of liquidity on stocks and bonds. How about options? Does illiquidity of an option affect its price? Thus far, to our knowledge, this issue has not been discussed in the microstructure literature. 3 for their helpful comments and suggestions. Special thanks to Ken Garbade for spending many hours reading and commenting on every draft of this paper. Many thanks to the Bank of Israel and the Tel-Aviv Stock Exchange for providing the data and responding to our innumerable questions. Finally, we thank René Stulz and the referee of this paper for their many helpful comments and suggestions.

Liquidity and Asset Prices

“…Chinese "restricted institutional shares," which can be traded only privately, trade at a discount of about 80% relative to exchange-traded shares in the same company (Chen and Xiong, 2001). Options that cannot be traded over their life trade at large discounts relative to identical tradable options (Brenner et al, 2001). The put-call parity is sometimes violated when it is difficult to sell short, implying that a stock trades at a higher price than a synthetic stock created in the option market (Ofek et al, 2004).…”

“…In Israel, the Bank of Israel issues European call options on the U.S. dollar paid in NIS (the Israeli currency), which are non-negotiable. Brenner et al (2001) compare these options to ordinary options traded on the Tel Aviv Stock Exchange that are similar in their payoff but differ in their liquidity, the latter being far more liquid than the former. Brenner et al compare the prices of three-and six-month at-the-money-forward options auctioned by the Bank of Israel, which are illiquid, to the sameday prices of synthetic publicly-traded options with a similar strike price and expiration date that they generate using the liquid options (period: 4/1994-6/1997, 272 and 127 options of 3 and 6 months, respectively).…”

Liquidity effects and FFA returns in the international shipping derivatives market

“…However, there are only a few studies that have examined the effect of liquidity on derivatives markets (see Brenner et al 2001, Bongaerts et al 2011and Deuskar et al 2011 and none, to the best of our knowledge, on shipping freight derivatives markets. In this study, a panel-estimation methodology is used to examine the effects of liquidity, as expressed by the Amihud illiquidity measure (Amihud, 2002) and the bid-ask spread on FFA excess returns after controlling for industry-specific and macroeconomic variables.…”

On the liquidity of CAC 40 index options market

“…Most studies analyze how the liquidity of the underlying asset could affect options' liquidity. For instance, Brenner et al (2001) consider non-tradable versus tradable currency options issued by the Bank of Israel. They provide evidence that liquidity has effect on the pricing of these options.…”